Three Reasons Why Diageo Holds Long-Term Potential

Diageo Plc. recently reported flat sales and lower net income in its half-year earnings, amid a slowing spirits market in the U.S., “anti-extravagance” policies in China, and currency depreciation in Russia and Venezuela.Yet, the share price increased almost 10% in the last six months, in line with the Dow Jones 30 index. In spite of the headwinds the alcohol beverage giant is set to face in the short run, the business has solid growth potential, and here’s why.

Firstly, Diageo is the owner of some of the most iconic brands in the world such as Smirnoff, Johnnie Walker, Baileys, Don Julio, and Guinness, all of which are the market leaders in their respective categories. More recently, many key brands such as Smirnoff and Johnnie Walker have experienced a drop in sales with a slowdown in the U.S. spirits market, sluggish growth in Europe, and a crackdown on lavish spending in China. In spite of this, we expect considerable demand for these brands in Latin America, Africa, and Asia-Pacific in the long term. Emerging markets currently account for approximately 42% of the total sales.We expect net sales in emerging markets to benefit from higher disposable incomes, which are expected to grow by approximately 5.6% going forward, as opposed to 2.3% in more advanced countries.Even in developed markets such as the U.S. and Europe, Diageo’s world-class brands hold a competitive advantage that is sure to remain for a long time to come.

Secondly, Diageo stands to benefit from the nature of the product that it sells. Mostly, demand for alcohol is not as sensitive to business cycle fluctuations as other products. While individuals may trade down to cheaper alternatives during tougher economic situations, the business does not usually battle steep demand declines during downturns. Diageo is expected to benefit even on this front, with a product portfolio ranging from ultra premium offerings such as Cîroc and Blue Label to value offerings such as VAT 69 and Rowson’s Reserve. Moreover, the fact that Diageo dabbles across spirits, beer, and wine categories also safeguards it to a large extent against changes in tastes and preferences of consumers.

Lastly, certain changes within the organization are also suggestive of higher potential for the business in the long term. Recently, Diageo has taken a number of steps to improve cash flows, which more than doubled in the first half of fiscal 2015 (ending June) in spite of flat sales and lower net incomes. Diageo has set forth plans to cut costs and improve efficiency to be able to save approximately £200 million (or $304 million) per year by June 2017.Furthermore, since February 1, the alcohol beverage giant has moved into a new procurement process, whereby payment to suppliers happens after 90 days instead of 60 days. Although the move is largely frowned upon by the Forum of Private Businesses, it is expected to leave the company with more cash at its disposal going forward. In order to aid suppliers with their cash flow requirements, Diageo also offers a supplier financing program, which will give suppliers access to cash prior to their normal payment.

However, Diageo’s current challenges are expected to persist in the short term. In the face of a slowing U.S. spirits market, the company’s biggest disadvantage lies in its lack of price competitiveness, with brands such as Smirnoff and Captain Morgan Spiced selling at an almost 25% premium to its biggest competitors.Although some impact of this is being offset by further innovations in new flavors and new marketing campaigns, a significant price cut may be required to increase brand appeal. Moreover, the negative impact of the anti-extravagance policies in China on alcohol sales are expected to persist at least until 2017. Hence, although we remain bullish about Diageo’s long-term prospects due to a strong brand portfolio and potential growth in emerging markets, headwinds in mature markets and China are expected to weigh on the company’s financials in the near term.

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